By Eitan Weinstock
Loan originators should be well aware of the looming CMBS (commercial mortgage-backed securities) maturities coming from 2015 to 2017, as they total 60 percent of outstanding CMBS loans. Of these maturing loans, 20 percent will require additional capital upon the loan’s refinance or property sale, according to data from Trepp, a provider of information, analytics and technology to the global CMBS, commercial real estate and banking industries. The availability of replacement financing at maturity is a mounting concern.
In light of this uncertainty, coupled with the current low interest-rate environment and salient forecasts of impending rate hikes, savvy borrowers have already begun transacting prepayments, and the booming defeasance industry is expected to be exceedingly active.
Despite the significant uptick in transactions over the past two years, defeasance remains an unfamiliar topic to many professionals in the commercial real estate finance arena, including self-storage owners and investors. Being well-versed in the available prepayment options will ensure you make the most cost-effective decisions.
Settling commercial debt prior to maturity typically requires borrowers to transact one of two common prepayment processes: yield maintenance or defeasance. Both prepayment options achieve the same goal of enabling borrowers to exit their financing while ensuring lenders and CMBS investors realize the same yield they would have received had the loan reached maturity. Despite the identical objective, yield maintenance and defeasance are fundamentally distinct.
In short, yield maintenance is the repayment of the loan while defeasance is the substitution of loan collateral. With yield maintenance, the borrower pays off the loan’s unpaid principal balance plus a penalty of at least 1 percent of the loan balance. With defeasance, a portfolio of securities that will continue to make loan payments on the borrower’s behalf replaces the real estate collateral underlying the loan. Unlike yield maintenance, there’s no minimum prepayment penalty with a defeasance, as the penalty is a direct function of the cost to purchase the securities portfolio.
Whether yield maintenance or defeasance is the most cost-effective option for a borrower depends heavily on the parameters written in the loan documents and the market conditions at the time of prepayment. In general, however, assuming prepayment language favorable to the borrower, defeasance is the least expensive option in a rising-interest-rate environment.
Defeasance terms favorable to the borrower include the ability to defease to the loan’s open window and the use of agency securities as permissible defeasance collateral. Conversely, unfavorable terms require defeasance collateral that will make payments through the loan’s maturity date and would restrict the collateral to U.S. Treasuries only.
Favorable yield-maintenance terms would dictate that U.S. Treasury rates not be decompounded monthly and payments be calculated to the prepayment date with a minimum 1 percent penalty. Unfavorable terms include decompounding the U.S. Treasury rate to a monthly rate and calculating payments to the maturity date with a minimum 3 percent penalty.
Whereas yield-maintenance penalties remain standard as a percentage of the loan balance, defeasance penalties are less clear to borrowers as they look to get out of their current fixed-rate loans. The costs associated with defeasance—and the potential rewards of opportune timing—are best explicated with the hypothetical savings scenario outlined below.
With the cost to defease tied directly to the cost of U.S. Treasuries (i.e., the higher the cost of Treasuries, the higher the cost to defease), many owners have dismissed defeasance as impractical, especially those with several years remaining until loan maturity. Since 2008, the cost to defease has ranged from 4 to 6 points per year remaining on the loan, leading many borrowers to “sit” on their loans rather than sell or refinance. However, trends over the past two years show borrowers are defeasing loans with longer remaining terms.
While penalties still range from tens of thousands to tens of millions of dollars, many borrowers can actually save considerable amounts by defeasing today (see the table below for sample analysis). For borrowers looking to take advantage of today’s lending market, defeasance presents the opportunity to move from 5.5 percent to 7.5 percent rates into 3.5 percent to 4.5 percent rates while protecting themselves against probable interest-rate increases over the next few years. In many cases, defeasing today means negating interest-rate risk at a minimal cost.
For example, for a borrower with a principal loan balance of $10 million originated in June 2007 at a 6 percent interest rate, the potential cost savings from defeasing now will be approximately $562,000 based on current interest-rate forecasts. As illustrated in the table, the total cost to defease today will be approximately $1.04 million, while total interest-payment savings recognized by locking in a new 10-year loan at 4 percent interest rather than 5.5 percent interest would be approximately $1.6 million, resulting in a net profit of $562,094.63. Should interest rates move above 5.5 percent, these costs will be even more substantial.
Moreover, for borrowers looking to lower their defeasance costs by waiting for yields on U.S. Treasuries to rise, it should be noted this strategy will most often have only a minimal impact. For example, should the borrower choose to delay his defeasance until the relevant U.S. Treasury rates have risen 10 basis points, his savings will be approximately $21,000. While these savings are certainly helpful, they pale in comparison to the potentially hundreds of thousands of dollars in increased interest costs the borrower risks by delaying his refinance.
Indeed, most borrowers view defeasance as a U.S. Treasury-rate game, believing they should delay their defeasance as long as possible to lower their costs. However, as the table demonstrates, the rewards associated with defeasing today can often outweigh the rewards of delay.
The process of defeasance is complicated and involves an array of professionals including accountants, attorneys, brokers, consultants, rating agencies and trustees. Consulting firms have become a standard component to defeasance transactions, retained by borrowers to help maneuver the process and minimize costs. While the process itself is relatively standard, each loan contains unique attributes that some consultants maximize to the benefit of their clients.
In addition to ensuring the process runs smoothly, the defeasance consultant is also responsible for structuring the portfolio of optimized securities, typically U.S. Treasuries or agency securities, which will match the debt-service payments of the original loan while still adhering to legal and industry standards. Strict guidelines govern how much cash may be included, month-end balances have limits throughout the life of the loan, and a large universe of bonds exists from which to construct the portfolio.
Ultimately, since market conditions are subject to indistinct fluctuations, brokers should advise clients to negotiate both yield maintenance and defeasance options in the prepayment clause of new originations to ensure the most cost-effective prepayment down the road. If the language of the existing loan documents allows for prepayment via defeasance, brokers should encourage borrowers to defease their loan now to capitalize on current market conditions while at the same time mitigating debt-availability crises come 2017.
Eitan Weinstock is the senior defeasance analyst at AST Defeasance in Los Angeles. The company offers defeasance services and has closed more than 200 defeasances with balances totaling more than $2 billion. For more information, call 866.333.3273; e-mail [email protected]; visit www.astdefeasance.com.